Dollar gains on trade data; rate uncertainty hits yen

WanfengZhou

NEW YORK (MarketWatch) -- The dollar rose to one-week highs against the euro and yen Wednesday after data showed a narrower-than-expected U.S. trade deficit in May and as investors cautiously awaited the Bank of Japan's interest-rate decision later in the week.

The U.S. trade deficit widened by 0.8% in May to $63.8 billion as both imports and exports set monthly records, the Commerce Department said Wednesday. Economists expected the deficit to widen to $64.7 billion. See full story.

The data were "better than expected and taken as dollar positive," said Kathy Lien, chief strategist at FXCM. However, markets will look to next week's capital flows data to see if inflows were sufficient to fund the trade gap, she said.

Late in New York, the euro stood at $1.2701, compared with $1.2773 late Tuesday, after touching $1.2671, the lowest level since June 30. The dollar rose to 115.70 yen, the highest level since July 5. It last changed hands at 115.49 yen, compared with 114.17 yen.

The British pound traded at $1.8346, compared with $1.8469. The dollar was at 1.2336 Swiss francs, compared with 1.2257 francs. The euro was at 146.69 yen compared with 145.87 yen. See live currency prices.

"With market players shifting their focus to Friday's BOJ decision and U.S. retail sales report, the dollar appears to be back in favor," said Michael Woolfolk, senior currency strategist at the Bank of New York. "As market volume and liquidity continues to dry up amidst the perennial summer doldrums, the dollar looks squarely range-bound for the time being."

Rate uncertainty weighs on yen

Meanwhile, the yen fell sharply amid uncertainty over the Bank of Japan's monetary policy. The BOJ is widely expected to raise interest rates Friday for the first time in six years, but speculation rose Wednesday that the statement accompanying the rate hike may be less aggressive than expected.

The yen showed no reaction to a news story that suggested a quarter percentage point rate hike is "a done deal," according to Brian Dolan, director of research at Forex.com, a division of Gain capital.

The BOJ's policy committee is likely to lift its target rate for the unsecured overnight call money rate to 0.25% during its policy meting that begins on Thursday, according to a story in the Thursday morning edition of the Nihon Keizai Shimbun, Japan's leading financial daily newspaper.

Along with the target rate hike to 0.25%, the official discount rate would likely be lifted from the current 0.1% to a range between 0.4% and 0.5%, the Nikkei report said, without citing sources.

Nikkei reported that the policy board, led by Governor Toshihiko Fukui, is expected to make a statement following its two-day meeting to assert that rates will be maintained at an extremely low level and that the bank won't rush to implement additional rate increases. See full story.

The news "doesn't seem to affect the New York market at all," Dolan said. "We'll first see Tokyo [market] reacting to that. If it [the story] is new to them, then we definitely will see a reversal lower in dollar/yen."

Japan's Finance Minister Sadakazu Tanigaki said Wednesday that deflation isn't over and there's no need for the central bank to rush the ending of its zero-rate policy as there is no inflation concerns.

"Though the remarks are not likely to stop the BOJ from hiking this week, they had some resonance as there is a thread of expectation in the market that the central bank will not signal a hawkish policy bias at Friday's meeting," said currency strategists at research firm Action Economics.

Adding to the yen's woes, Japan's domestic corporate goods prices index rose 3.3% in June from a year earlier, weaker than expectations of 3.4%, data from the Bank of Japan showed.

Though remaining at a 25-year high, the index was weaker than expected "suggesting that inflationary pressures were well easing in world's second largest economy," said Boris Schlossberg, senior currency strategist at FXCM.

Schlossberg said any near-term rate moves in Japan "will be modest and limited, at best" and the yen will remain the preferred funding currency for carry trades "until such time that the Federal Reserve unequivocally signals the end of its tightening campaign putting an end to the widening of the interest rate differential between the two currencies."

Yen carry trade has gone on for many years in the foreign-exchange market. Speculators have been making profits by borrowing yen at almost no cost and reinvesting in higher-yielding currencies and assets.

Trade balance improves

Reflecting a growing global economy, U.S. exports increased 2.4% to $118.7 billion, the biggest percentage gain since December 2004. Record imports for petroleum, led by record prices and record quantities, helped to push up imports by 1.8% to $182.5 billion. The non-petroleum deficit fell to $43.2 billion, its lowest level in nine months.

In the first five months of the year, imports are up 12.3% compared with the first five months of 2005. Exports are up 12.0% year-to-date. The year-to-date deficit is up 12.8% to $317.9 billion. Last year, the deficit totaled a record $716.7 billion. Read the full government report.

"The 'core' trade balance is already improving and this could take some of the sting from potential [Group of Seven] efforts to make the dollar bear a greater part of the adjustment process," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.

"The dollar should get a small boost from today's report," said Daniel Jester, an economist at Moody's Economy.com. "Going forward, a weaker dollar, cooler growth in the U.S. and firm demand abroad should keep the trade deficit from growing much further this year, though tangible improvement may not become evident until 2007."

But Bank of New York's Woolfolk warned that although recent trade gap data have showed some sustained improvement, any lasting market enthusiasm is "firmly misplaced."

"Energy prices continue to rise and China remains resistant to further currency appreciation. Without yuan appreciation, the global imbalances problem is expected to continue growing," he said.

"Even though the trade deficit number is bit more promising, the big event is if the Federal Reserve will raise interest rates again in August," she said. "Bernanke's speech next week is extremely important."

The Federal Reserve raised its federal funds target rate to 5.25% on June 29, the 17th such increase in the past two years. Higher interest rates make the dollar more attractive as an investment compared with the euro and yen.

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